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Catalog Analysis: Understanding Catalog Profit & Loss

During the past several months we have looked at financial formats for catalogs and the Internet from a global or financial model standpoint. We contrasted the differences between consumer and business financial models, and last month we looked at the financial model and impact of the Internet on direct sellers who have a strong Web component.

Bankers and accountants know about managing and handling revenue and costs, but few of the traditional financial service providers have a decent understanding of catalog and Internet marketing. A traditional profit-and-loss (or income) statement used by a manufacturing company or a retail business is dramatically different from that used by direct marketers.

The differences in brief

A retail or manufacturing P&L statement

tends to lump together all selling, general, and administrative expenses

has little or no breakout of individual category expenses for fulfillment, catalog creative and mailing expenses, other advertising and promotional expenses, or administrative costs

includes all sales from merchandise as well as any other miscellaneous income from list rentals or shipping-and-handling fees in gross revenue

lumps together returns, cancellations, and other deductions and subtracts them from gross revenue

is produced at the end of each month, quarter, and year, and is seldom configured in connection with or after any promotional event.

On the other hand, a catalog or Internet company P&L statement

separates all expenses by applicable category such as returns, cancellations, cost of goods, fulfillment, advertising and promotion, and overhead (true general and administrative expenses)

includes exact subcategory costs so that catalogers can build benchmark ratios such as cost to fulfill an order; variable cost of the catalog’s printing, paper, mailing, and postage (cost of the catalog in the mail); cost to get a new customer; lifetime value of a customer; and ratio of administrative costs to sales.

are driven primarily for catalogers to measure promotional events — though there are still the traditional monthly, quarterly, and annual statements. (We’ll discuss this in greater detail in our next column.)

The two charts on this page depict sample income statements for hypothetical companies. The chart below shows how a typical retailer or manufacturer might present a monthly statement. A picture of brevity, this income statement includes income from all sources in its gross sales or revenue. Returns, cancellations, bad debt, and any other top-line deductions are subtracted from gross sales to obtain net sales. Cost of goods (often called cost of sales) is then deducted to provide gross margin. Finally, all selling, operational, and general and administrative costs are combined and deducted from gross margin to produce contribution to profit, or EBIT (earnings before interest and taxes.) How simple can you get? And what a contrast to a direct marketing P&L.

The chart on the left indicates how a catalog/ Internet seller typically portrays a promotional event P&L. This format is more or less the acceptable standard used by the industry. The detail allows direct marketers to measure every aspect of their businesses and to compare their results against standards for their industry segment or for businesses of a comparable type and size. Let’s take a closer look at how different these two P&L statements are.

The catalog/Internet P&L

Let us examine each of the direct marketing revenue and cost segments in more detail to understand the rationale of why they measure what they do.

Gross sales: This represents gross merchandise demand by customers for products being offered in your catalog or via the Internet. Catalogs need to capture total demand for goods and then measure and track returns and cancellations. Shipping-and-handling income is usually moved from gross sales to an offsetting cost under fulfillment.

Returns: Representing items being returned for credit or refund, this line is a deduction from gross sales. Many catalogs will also experience exchanges, which are not returns but customers exchanging one product for another — for reasons of fit, color, or personal preference. While there is a fulfillment cost of processing them, exchanges are not a reduction of gross sales. There is no normal or average return rate for all catalogs, though apparel books have much higher return rates — 15%, 20%, or even upward of 25% — while hard goods, food, and business-to-business catalogs have much lower returns. You must remember that while returns can occur throughout the catalog’s cycle, they typically come in 30-60 days after sales are booked.

Cancellations: Another reduction from gross sales, cancellations are typically credit-card- or check-related, or backorder-related. If customers write you bad checks or if their credit cards are wrong, maxed out, or fraudulent, you are unable to complete the sale. Hopefully you’ll have discovered this sort of problem before you ship the goods. The second, more common type of cancellation is merchandise-related. In this case, the product might be on backorder, such as at the end of the catalog cycle or because of a vendor delivery problem.

Cancellations are a reduction of gross sales and usually occur at the beginning of the order entry process. And not unlike returns, cancellations will vary widely by type of catalog.

Net sales: This is what is left from gross merchandise demand after deducting returns and cancellations, net sales is what you deposit in the bank (from which you will pay expenses). Final net sales cannot be read until all demand is complete and returns are in (usually about six months after the catalog drop). In all cases, net sales are the starting point (100%) from which all other costs are figured.

Cost of goods: Look at the catalog P&L format chart and note all of the elements that go into cost of goods. Because the cost of goods is such a large cost center in the entire P&L, it becomes a key driver of catalog economic success. Among the elements: cost of the product, which varies dramatically by type of company; freight to your warehouse (freight-in); and the cost of markdowns and remaindering of product at the end of a season.

A word about markdowns: Retailers rely on them heavily to clear out overstocks, while catalogers and Internet merchants typically have numerous additional ways to recover product cost when goods are declared “excess.” Markdowns for direct marketers are therefore typically low or nonexistent. Not that catalogers necessarily shy away from cutting pricing to move obsolete stock, of course.

The objective in marking down the selling price is to still recover your cost of goods. Say a cataloger buys an item for $40 and initially sells it for $100. The cataloger has a 40% cost of goods, or a 60% gross margin. If the item cannot be sold for the full $100 price, the seller reduces the price and therefore reduces the gross margin. There is not an additional cost of goods with a markdown, but if ultimately if the item is sold for less than $40, the catalog is not recovering its original cost of goods. In effect, the company has increased its cost of goods as a percentage of sales to remainder merchandise that is declared excess.

Also included under cost of goods are two offsetting credits. Both represent ways successful merchants can reduce their cost of goods. Co-op advertising or freight allowance is typically placed with the cost of goods on the P&L (rather than with advertising or promotion) since the product buyers normally negotiate them. Smart merchants are very aggressive about asking for and collecting these allowances, which are fees or discounts from product vendors toward the production costs of including the item in the catalog. The final credit is cash discounts — paying early to take advantage of discounts for timely payment of invoices.

Gross margin: This is what’s left after the cost of goods is subtracted from net sales. Margins are a critical economic driver of success for catalog and Internet businesses. It is said that cataloging is a “margin driven” business. Improve the margin by 1%, and that gain drops directly through to contribution to overhead and profit. Lose a point in margin, and it directly affects the bottom line.

In our next column we will examine the other costs, such as fulfillment, advertising or promotion, and administrative expenses, that catalog and Internet companies must work hard to understand and track. We will also discuss uses and applications for the P&L in the day-to-day management of the catalog.

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